Revisiting M&M with Taxes: an Alternative Equilibrating Process
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International Journal of Financial Studies Article Revisiting M&M with Taxes: An Alternative Equilibrating Process Kenneth J. Kopecky 1,*, Zhichuan (Frank) Li 2,*, Timothy F. Sugrue 3 and Alan L. Tucker 4 1 Department of Finance, Fox School of Business, Temple University, Philadelphia, PA 19122, USA 2 Department of Finance, Ivey Business School, University of Western Ontario, London, ON N6G 0N1, Canada 3 Department of Finance, School of Business, Clarkson University, Potsdam, NY 13699, USA; [email protected] 4 Independent Researcher, Newtown, PA 18940, USA; [email protected] * Correspondence: [email protected] (K.J.K.); fl[email protected] (Z.L.); Tel.: +1-386-957-3372 (K.J.K.); +1-519-661-4112 (Z.L.) Received: 24 October 2017; Accepted: 8 January 2018; Published: 16 January 2018 Abstract: Modigliani and Miller present an equity-quantity shifting equilibrating process to achieve an optimal firm value in the presence of corporate taxes. However, in the era in which they derived their various propositions regarding the relation between a firm’s value and its capital structure, well-capitalized takeover specialists including private equity firms and sovereign funds did not exist, at least by today’s standards. In this paper we develop a simple arbitrage strategy, made viable by the presence of takeover firms, which presents an alternative equilibrating process to achieve the same optimal firm value. This alternative process is markedly different from that of the Modigliani and Miller theorem in terms of its predictions for debt use and restores the prospect of capital structure irrelevancy despite the existence of corporate taxes. Keywords: capital structure; debt; interest deduction; equity price adjustment JEL Classification: G30; G32 1. Introduction In their seminal paper, Modigliani and Miller(1963) (“MM63” hereafter) demonstrate that in the presence of corporate taxes with the ability to expense the interest paid on its debt, a firm’s value is maximized by all-debt financing. To achieve their corner solution equilibrium, MM63 tacitly rely on the existence of a liquid debt market. Firms can readily lever their capital structure by issuing debt and retiring equity in a strategy that may be aptly described as “equity-quantity shifting”. The issuance of debt necessitates a competitive credit market, i.e., one that is “deep” or price elastic. Given the existence of organized debt markets with large institutional participants at the time, MM63’s reliance on an equity-quantity shifting equilibrating process is clearly reasonable. However, capital markets have changed considerably since the era in which Modigliani and Miller (“MM”) derived their various propositions regarding capital structure. Such change motivates us to investigate whether MM63’s equity-quantity shifting equilibrating process is unique, or instead if the same optimal firm value can be obtained via an alternative no-arbitrage process. A major change in capital markets is the advent of well-capitalized takeover firms including private equity firms and sovereign funds. These entities did not exist during the MM era, at least by today’s standards. In this paper we demonstrate that the existence of such entities gives rise to a viable alternative equilibrating process that we dub “equity-price shifting”. As demonstrated herein, this alternative no-arbitrage process is as straightforward and achievable as the equity-quantity shifting process of MM63, and it leads to the same optimal firm value. Int. J. Financial Stud. 2018, 6, 10; doi:10.3390/ijfs6010010 www.mdpi.com/journal/ijfs Int. J. Financial Stud. 2018, 6, 10 2 of 12 The intuition behind our approach is simple, and is grounded in sound economic theory as old as that of Pareto: If a firm “X” is under-levered, a private equity firm “Y” will be incentivized to buy X’s stock and optimally re-capitalize firm X. However, in an efficient equity market the stock price of firm X will reflect the takeover pressure, which logically implies that the presumably lost value due to under-leverage is already captured in firm X’s stock price. Thus, there is no need to actually issue debt. To use an analogy, Pareto’s theory demonstrates that if there are two fields, one with crops and the other fallow, the fallow field will command a nearly equal price to the one with crops because of the prospect of sowing and reaping the fallow field. Importantly, one does not have to actually grow crops on the fallow field in order for its market value to remain close to that of the other field. The mere prospect of growing crops will ensure a small difference in values, if viable buyers of the fallow field exist. Similarly, the difference between the values of two firms, one levered and one not, will be small in the presence of corporate taxes, even if the latter firm remains unlevered, because of the prospect of levering the all-equity firm, i.e., the existence of a viable takeover entity that will buy and financially restructure the under-levered firm. In the era of MM, there were few takeover entities. Thus, an equity quantity-shifting process, i.e., actual debt issuance, was required to optimize firm value. However, today’s markets are replete with well-financed takeover firms and active take-over markets now exist in many countries. As perverse as it may initially seem, in today’s market environment we do not actually require the issuance of debt in order to capture the value presented by the debt-induced interest tax credit—just as we do not need to actually grow crops in order for our fallow field to command a value close to that of a field with crops. The benefit of the interest debt shield may be already reflected in the equity component of a firm’s value. If the equity-quantity shifting mechanism of MM63 and our equity-price shifting mechanism both lead to the same optimal firm value, then why might one be interested in the equity-price shifting process? The answer to this question lies in its consequences for observed debt use. It has been observed that, contrary to the implications of the traditional static tradeoff model of capital structure choice, many corporations appear to possess sub-optimal capital structures because they do not fully utilize the debt tax shield (cf. Miller 1977; Graham 2000). Explanations advanced to resolve this under-leverage puzzle have focused on leverage mis-measurement (cf. Welch 2011) and distress costs mis-measurement (cf. Almeida and Philippon 2007); the existence, but empirical omission, of non-debt tax shields including tax shelters (cf. Graham and Tucker 2006; Lin et al. 2014) and pension contributions (cf. Shivdasani and Stefanescu 2010); and the omission of international tax considerations (cf. Huizinga et al. 2008). In this paper we propose an alternative theoretical explanation to this empirical puzzle that is unrelated to the aforementioned explanations. More specifically, we present a partial equilibrium debt tradeoff model that, through the introduction of a takeover market and a simple trading strategy, demonstrates the optimality of lower leverage for a cohort of firms, and, moreover, that this apparently sub-optimal capital structure can persist even in the absence of any special debt-corporate conflicts. The cohort of firms is likely to consist of firms whose equity can be absorbed by potential acquirers such as private equity firms.1 The above result depends on two reasonable assumptions: First, a friction exists in the form of a fixed cost associated with corporate recapitalization. Second, there exists today a takeover market that is reasonably competitive and efficient.2 Given these two assumptions we show that the stock 1 The equilibrating force presented in this paper does not require the takeover firm to be a private equity firm. Other institutional investors are potential candidates. Moreover, still other investors—knowing that private equity and other takeover firms may act—may be incentivized to purchase the stocks of the sub-optimally capitalized firms, thus providing for an overall larger pool of capital to finance the purchase of these stocks. 2 The notion that external markets can influence the investing, financing, and other decisions of a firm (and, therefore, its value) is not novel. For example, the existence of a hostile takeover market is often cited as a reason for managers to limit their costly agency behaviors. Also, the equilibrating process in standard tradeoff models relies on the existence of a deep external debt marketplace that allows firms to increase their leverage in order to pocket the interest tax shield associated with debt financing. Int. J. Financial Stud. 2018, 6, 10 3 of 12 value of a firm that does not recapitalize in the presence of a tax shield is not necessarily determined by the standard discounted cash flow model. Furthermore, we show that the fixed internal cost of recapitalization, paid either explicitly or implicitly with the firm’s resources, may be only one component of the recapitalization cost perceived by the firm. Even if this internal cost is known and it appears optimal to recapitalize internally, a firm may nonetheless opt to remain with an apparently sub-optimal capital structure. In this regard, our model also provides insight into the observed rigidity of within-firm capital structures (cf. Fama and French 2002), at least for a cohort of firms. As their name suggests, tradeoff models attempt to determine an optimal capital structure by weighing the costs and benefits of debt utilization. Empirically, tradeoff models—either static or dynamic, and whether estimated at the cross-sectional or within-firm level—have largely provided an inadequate fit for the data. A prominent work by Graham and Leary(2011) reviews the major theories, including trade-off theory and its shortcomings; it is important to study the trade-off theory further as it maintains a prominent position, to this day, in the literature, textbooks, and classroom.